Rev. Rul. 79-275

ISSUE

Does the distribution by a corporation to its shareholders of appreciated securities in substitution of a note received upon the sale by the corporation of the assets of one of its businesses qualify as a distribution in partial liquidation within the meaning of section 346(a)(2) of the Internal Revenue Code?

FACTS

X corporation has been in the poultry processing business since its incorporation in 1965. In 1968 X went into the chicken farming business as a separate and distinct operation. After several years of profitable operation, the chicken farming business began to lose money. Because of this, the management of X decided to completely terminate the chicken farming business. In June, 1978 all the chicken farm properties of X were sold for 100x dollars. Payment was represented by a note, which was secured by a mortgage, payable over a 10 year period. X continued to engage in the poultry processing business.

Following the termination of the chicken farming business X adopted a plan of partial liquidation on September 5, 1978. In lieu of distributing the note and mortgage that X had received from the sale of the farm properties, X distributed appreciated marketable securities the fair market value of which was equal to the fair market value of the note. These marketable securities had been used by X as working capital in the poultry processing business. The distribution was pro rata to the shareholders of X, was pursuant to the adopted plan of partial liquidation, and occurred within the taxable year in which the plan was adopted. Each shareholder turned in for cancellation and redemption a portion of his or her stock in the corporation equal in value to the value of the distribution received.

LAW AND ANALYSIS

The applicable sections of the Code are sections 346(a)(2), relating to a contraction of a business in a partial liquidation; section 346(b), relating to the termination of a business in a partial liquidation; and section 311(d)(1), relating to the distribution of appreciated property in redemption of stock.

If the distribution satisfies the safe harbor requirements of section 346(b) of the Code then it would be considered not essentially equivalent to a dividend for purposes of section 346(a)(2). If it does not satisfy the requirements of section 346(b), then a separate determination of nondividend equivalence must be made for purposes of section 346(a)(2). In either case, the distribution will qualify as being in partial liquidation within the meaning of section 346(a)(2) only if the other two requirements of that section are met--namely, the distribution is in redemption of a part of X's stock pursuant to a plan and occurs within the taxable year in which the plan is adopted or within the succeeding taxable year.

The stock of X was redeemed pursuant to a plan of partial liquidation, the redemption occurred within the taxable year in which the plan was adopted, the sale of the chicken farming business for 100x dollars constituted the necessary contraction (termination) of the corporate business, and the value of the assets distributed was equal to the amount attributable to such contraction. Therefore, the issue to be resolved is whether the distribution of marketable securities in lieu of the note and mortgage can be treated for purposes of section 346(b) of the Code as being a distribution that is attributable to X's ceasing to conduct the chicken farming business and if not, does the distribution qualify as not essentially equivalent to a dividend within the meaning of section 346(a)(2).

The term "attributable to" contained in section 346(b)(1) of the Code is descriptive of the proceeds from the sale of the assets of the terminated business. Baan v. Commissioner, 51 T.C. 1032 (1969), aff'd per curiam, 450 F.2d 198 (9th Cir. 1971), and aff'd sub nom., Gordon v. Commissioner, 424 F.2d 378 (2d Cir.), cert. denied, 400 U.S. 848 (1970); S. Rep. No. 1622, 83d Cong., 2d Sess. 49, 262 (1954). In order to qualify under section 346(b), the distribution must include all of the assets of the terminated business or the proceeds of the sale of such assets. Furthermore, only the assets of the terminated trade or business, or the proceeds from the sale of such assets, or a combination thereof, can be distributed in a distribution qualifying as a partial liquidation under section 346(b). Since the marketable securities were not the proceeds from the sale of the chicken farming business, but, instead, were distributed in lieu of the proceeds, their distribution was not "attributable to" X's having ceased the conduct of the chicken farming business. Accordingly, the entire distribution does not qualify under section 346(b).

Thus, a determination must be made as to whether the distribution is not essentially equivalent to a dividend within the meaning of section 346(a)(2) of the Code. In 1954 Congress separated the previously combined concepts of "redemption" and "partial liquidation" and provided that the latter included those distributions characterized by what happens solely at the corporate level by reason of the assets distributed. Congress also made it clear that a distribution resulting from the contraction of a corporate business would fall within the general language of section 346(a)(2) of the Code. S. Rep. No. 1622, 83d Cong., 2d Sess. 49 (1954). Therefore, it is the type of assets that are distributed that distinguishes a "redemption" from a "partial liquidation". If the assets that are distributed are related to the contraction of the corporate business, then the distribution will be treated as a partial liquidation. On the other hand, if there is no nexus between the assets distributed and the corporate contraction, then the transaction must be measured for dividend equivalence under section 302. In order to distinguish between a distribution of assets that are related to the contraction and a distribution of assets that are not related to the contraction, the Internal Revenue Service has required a segregation of the proceeds of the sale of the assets, and has further required that the assets or the proceeds not be used in the remaining corporate business for any period of time. Rev. Rul. 76-279, 1976-2 C.B. 99, amplifying Rev. Rul. 71-250, 1971-1 C.B. 112; Rev. Rul. 67-299, 1967-2 C.B. 138; Rev. Rul. 58-565, 1958-2 C.B. 140.

When the chicken farming business was sold, it was sold for consideration represented by a note and mortgage. The note and mortgage are the proceeds attributable to X's ceasing to conduct the chicken farming business and are the only assets that may be distributed by X in partial liquidation under section 346(a)(2) of the Code, other than a portion of the working capital of X reasonably attributable to the terminated business activity and no longer required in the operation of the remaining business activities.

HOLDING

X's distribution of marketable securities to its shareholders, in substitution for a note received upon the sale by X of the assets of its terminated chicken farming business, will not qualify as a distribution in partial liquidation within the meaning of section 346(a)(2) of the Code because the distribution does not qualify under either section 346(b) or as not essentially equivalent to a dividend within the meaning of section 346(a)(2). In order to qualify under section 346(b), the distribution must include all of the assets of the terminated business or the proceeds of the sale of such assets. In this case, the entire distribution will not qualify under section 346(b) since the marketable securities were not the assets or, nor the proceeds from the sale of, the terminated business. In addition, the entire distribution will not qualify as not essentially equivalent to a dividend within the meaning of section 346(a)(2) because the assets that are distributed are not related to the contraction of the corporate business. Since the distribution of the marketable securities is a pro rata distribution to all of the shareholders of X, it does not qualify under section 302(a) as payment in exchange for the redeemed stock attributable thereto. United States v. Davis, 397 U.S. 301 (1970), 1970-1 C.B. 62. Therefore, by virtue of section 302(d), the distribution is treated as a distribution of property to which section 301 applies.

Furthermore, under the provisions of section 311(d)(1) of the Code, X must recognize gain on the distribution to the extent that the fair market value of the marketable securities distributed exceeds the adjusted basis of such securities in the hands of X, because the distribution in redemption is not a complete or partial liquidation and because section 311(d)(1) applies regardless of whether section 301 applies.